Importance of Accounting

is a
Accounting

system that

Identifies

Records
information
Relevant

that is

Communicates

Reliable
Comparable
McGraw-Hill/Irw1in

to help users make

better decisions.
The McGraw-Hill Companies, Inc., 2006

Generally Accepted Accounting

Principles
Financial accounting practice is governed by
concepts and rules known as generally accepted
accounting principles (GAAP).
Relevant
Information

Affects the decision of

its users.

Reliable Information

Is trusted by
users.

Comparable
Information

Is helpful in contrasting
organizations.

McGraw-Hill/Irw2in

The McGraw-Hill Companies, Inc., 2006

Principles of Accounting General

Principles

Objectivity Principle
Accounting information is supported by independent,
unbiased evidence. It is intended to make financial
statements useful by ensuring they report reliable and
verifible information.

Source documents.
McGraw-Hill/Irw3in

The McGraw-Hill Companies, Inc., 2006

Principles of Accounting

Revenue Recognition Principle

Provides guidance on when a company must recognize
revenue.

1. Recognize revenue when it is earned.

2. Proceeds need not be in cash (Credit sales).
3. Measure revenue by cash received plus cash
value of items received.
McGraw-Hill/Irw4in

The McGraw-Hill Companies, Inc., 2006

Expanded Accounting Equation

Assets

Owner
Capital

McGraw-Hill/Irw5in

Liabilities

Owner
Withdrawals

+
Revenues

Equity

Expenses

The McGraw-Hill Companies, Inc., 2006

Double-Entry Accounting

Assets
ASSETS

Debit

Normal
Balance

McGraw-Hill/Irw6in

Credit

Liabilities
LIABILITIES

Debit

Credit

Normal
Balance

Equity
EQUITIES

Debit

Credit

Nomal
Balance

The McGraw-Hill Companies, Inc., 2006

Exh.
3.8

Double-Entry Accounting

Equity
Owners
Capital

Owners
Withdrawals

Revenues

Expenses

Capital

Withdrawals

Revenues

Expenses

Debit Credit

Debit Credit

Debit Credit

Debit Credit

Normal
Balance
McGraw-Hill/Irw7in

Normal
Balance

Normal
Balance

Normal
Balance

The McGraw-Hill Companies, Inc., 2006

Double-Entry Accounting
When there is a debited account, there must
be a credited account.
The total amount debited must be equal to the
total amount credited for each transaction.
The left side is the normal balance side for
assets, and the right side is the normal
balance side for liabilities and equity.

McGraw-Hill/Irw8in

The McGraw-Hill Companies, Inc., 2006

Analyzing and Recording Process

Assets

Liabilities

Equity

T- Account
(Left side)
(Right side)
Debit
Credit

Step 1: Analyze
transactions and source
documents.

ACCOUNT NAME:
Date

Step 2: Apply doubleentry accounting

GENERAL JOURNAL

ACCOUNT No.
Description

PR

Debit

Credit

Balance

Step 4: Post entry to ledger

McGraw-Hill/Irw9in

Date

Description

Page
Post.
Ref.

Debit

123
Credit

Step 3: Record journal entry

The McGraw-Hill Companies, Inc., 2006

After processing its remaining transactions for December,

FastForwards Trial Balance is prepared.
FastForward
Trial Balance
December 31, 2004

Cash
Accounts receivable
Supplies
Prepaid Insurance
Equipment
Accounts payable
Unearned consulting revenue
C. Taylor, Capital
C. Taylor, Withdrawals
Consulting revenue
Rental revenue
Salaries expense
Rent expense
Utilities expense
Total
McGraw-Hill/Irw10in

Debits
$ 4,400
9,270

Credits

2,400
26,000
$

6,200
3,000
30,000

600

The trial balance lists

all account balances
in the general ledger.
If the books are in
balance, the total
debits will equal the
total credits.

5,800
300
1,400
1,000
230
$ 45,300 $ 45,300
The McGraw-Hill Companies, Inc., 2006

Recognizing Revenues and Expenses

Revenue recognition principle requires that
revenue be recorded when earned, not before or
after.
Matching principle intends to record expenses in
the same accounting period as the revenues that
are earned as a result of these expenses.

McGraw-Hill/Irw11in

The McGraw-Hill Companies, Inc., 2006

Adjusting Accounts
An adjusting entry is recorded to bring an asset or
liability account balance to its proper amount.

Framework for Adjustments

Adjustments
Paid (or received) cash before
expense (or revenue) recognized

Prepaid
(Deferred)
expenses*
McGraw-Hill/Irw12in

Unearned
(Deferred)
revenues

*including depreciation

Paid (or received) cash after

expense (or revenue) recognized

Accrued
expense

Accrued
revenues

The McGraw-Hill Companies, Inc., 2006

Prepare
adjusted trial
balance.
Cash
Accounts receivable
Supplies
Prepaid insurance
Equipment
Accum. depr. - Equip.
Accounts payable
Salaries payable
Unearned revenue
C. Taylor, Capital
C. Taylor, Withdrawals
Consulting revenue
Rental revenue
Depr. expense
Salaries expense
Insurance expense
Rent expense
Supplies expense
Utilities expense
Totals
McGraw-Hill/Irw13in

FastForward
Work Sheet
For Month Ended December 31, 2004
Unadjusted
Trial Balance
Dr.
Cr.
3,950
9,720
2,400
26,000

Adjustments
Dr.
f

6,200
3,000 d
30,000

Cr.

1,800
b
a

1,050
100

375

210

Adjusted
Trial Balance
Dr.
Cr.
3,950
1,800
8,670
2,300
26,000

250
600

600
5,800

d
f

250
1,800

7,850

300
1,400
1,000
230
45,300

45,300

375
6,200
210
2,750
30,000

300
c
e
a

375
210
100

1,050
3,785

3,785

375
1,610
100
1,000
1,050
230
47,685

47,685

The McGraw-Hill Companies, Inc., 2006

FastForward
Sort adjusted
trial balance
Work Sheet
amounts
to Ended
financial
statements.
For Month
December
31, 2004

Cash
Accounts receivable
Supplies
Prepaid insurance
Equipment
Accum. depr. - Equip.
Accounts payable
Salaries payable
Unearned revenue
C. Taylor, Capital
C. Taylor, Withdrawals
Consulting revenue
Rental revenue
Depr. expense
Salaries expense
Insurance expense
Rent expense
Supplies expense
Utilities expense
Totals

McGraw-Hill/Irw14in

Adjusted
Trial Balance
Dr.
Cr.
3,950
1,800
8,670
2,300
26,000

Income
Statement
Dr.

Cr.

Balance Sheet &

Statement of Equity
Dr.
Cr.
3,950
1,800
8,670
2,300
26,000

375
6,200
210
2,750
30,000

375
6,200
210
2,750
30,000

600

600
7,850
300

7,850
300
375
1,610
100
1,000
1,050
230
47,685

47,685

375
1,610
100
1,000
1,050
230
4,365

8,150

43,320

39,535

The McGraw-Hill Companies, Inc., 2006

Financial Statements
Income Statement: revenues and expenses
together with the how much profit the firm makes.
Statement of Owners Equity: reports information
how equity changes over the reporting period.
Balance Sheet: a companys financial position at
a point of time.
Statement of cash flows: cash receipts and cash
payments over a period of time.

McGraw-Hill/Irw15in

The McGraw-Hill Companies, Inc., 2006

Temporary and Permanent Accounts

Income
Summary

McGraw-Hill/Irw16in

Liabilities

Permanent
Accounts

Owners
Capital

Temporary
Accounts

Assets
Withdrawals

Expenses

Revenues

The closing process

applies only to
temporary accounts.
The McGraw-Hill Companies, Inc., 2006

Accounting cycle
1. Analyze transactions

9. Prepare Post-closing
Trial balance

2. Journalize

8. Close

3. Post

7. Prepare statements

4. Prepare unadjusted
Trial balance

McGraw-Hill/Irw17in

5. Adjust

6. Prepare adjusted
Trial balance

The McGraw-Hill Companies, Inc., 2006

Inventory Systems
Beginning
inventory

Net cost of
purchases

+
= Merchandise

available for sale

Ending Inventory
McGraw-Hill/Irw18in

Cost of Goods
Sold
The McGraw-Hill Companies, Inc., 2006

Itemized Cost of Merchandise Purchased

Matrix, Inc.
Total Cost of Merchandise Purchases
For Year Ended May 31, 2005
Invoice cost of merchandise purchases
$ 692,500
Less:
Purchase discounts
(10,388)
Purchase returns and allowances
(4,275)
Add:
Cost of transportation-in
4,895
Total cost of merchandise purchases
$ 682,732

McGraw-Hill/Irw19in

The McGraw-Hill Companies, Inc., 2006

Accounting for Merchandise Sales

Matrix, Inc.
Computation of Gross Profit
For Year Ended December 31, 2005
Sales
Less:
Sales discounts
Sales returns and allowances
Net sales
Cost of goods sold
Gross profit

$ 2,451,000
$ 29,412
18,500

47,912
$ 2,403,088
(1,928,600)
$ 474,488

Sales discounts and returns and allowances are Contra Revenue accounts.
McGraw-Hill/Irw20in

The McGraw-Hill Companies, Inc., 2006

Inventory Cost Flow Assumptions

First-In, First-Out
(FIFO)

Assumes costs flow in the order

incurred.

Last-In, First-Out
(LIFO)

Assumes costs flow in the

reverse order incurred.

Weighted
Average

Assumes costs flow at an

average of the costs available.

McGraw-Hill/Irw21in

The McGraw-Hill Companies, Inc., 2006

Sales of Merchandise
On March 18, Diamond Store sold $25,000 of
merchandise on account. The merchandise was
carried in inventory at a cost of $18,000.
Mar. 18 Accounts Receivable
Sales

25,000
25,000

Sales of merchandise on credit

Cost of Goods Sold

18,000
Merchandise Inventory

18,000

To record cost of sales

McGraw-Hill/Irw22in

The McGraw-Hill Companies, Inc., 2006

Valuing Accounts Receivable

Some customers may not pay
their account. Uncollectible
amounts are referred to as
bad debts. There are two
methods of dealing with bad
debts:

Direct Write-Off Method

Allowance Method
McGraw-Hill/Irw23in

The McGraw-Hill Companies, Inc., 2006

Estimating Bad Debts Expense

Two Methods
1.
2.

Percent of Sales Method

Accounts Receivable Methods

McGraw-Hill/Irw24in

Percent of Accounts Receivable

Aging of Accounts Receivable
Method

The McGraw-Hill Companies, Inc., 2006

Percent of Accounts Receivable

Desired balance in Allowance for
Doubtful Accounts.

$ 100,000

4.00%
= $
4,000

Allowance for
Doubtful Accounts
900
3,100
4,000

Dec. 31 Bad Debts Expense

3,100
Allowance for Doubtful Accounts

3,100

To record estimated bad debts

McGraw-Hill/Irw25in

The McGraw-Hill Companies, Inc., 2006

Computing Maturity and Interest

Principal
of the
note
$ 12,000

Annual
interest
rate

9%

Time
expressed = Interest
in years
90/360

270

Total interest due

at May 30.
McGraw-Hill/Irw26in

The McGraw-Hill Companies, Inc., 2006

Factors in Computing Depreciation

The calculation of depreciation requires
three amounts for each asset:

Cost.

Salvage Value.
Useful Life.
McGraw-Hill/Irw27in

The McGraw-Hill Companies, Inc., 2006

Depreciation Methods

Straight-line
Units-of-production
Declining balance
McGraw-Hill/Irw28in

The McGraw-Hill Companies, Inc., 2006

Disposals of Plant Assets

Update depreciation
to the date of disposal.
Journalize disposal by:
Recording cash
received (debit)
or paid (credit).
Removing accumulated
depreciation (debit).
McGraw-Hill/Irw29in

Recording a
gain (credit)
or loss (debit).
Removing the
asset cost (credit).
The McGraw-Hill Companies, Inc., 2006

Selling Plant Assets

Determine Gain or Loss on Disposal
If Cash > BV, record a gain (credit).
If Cash < BV, record a loss (debit).
If Cash = BV, no gain or loss.

McGraw-Hill/Irw30in

Cost
Accumulated depreciation

$ 100,000
38,000

Book Value
Cash Received
Loss on disposal

62,000
60,000
$ (2,000)
The McGraw-Hill Companies, Inc., 2006

Known (Determinable) Liabilities

Accounts Payable
Sales Taxes Payable
Unearned Revenues
Short-Term Notes Payable
Payroll Liabilities
Multi-Period Known Liabilities
McGraw-Hill/Irw31in

The McGraw-Hill Companies, Inc., 2006

Estimated Liabilities
An estimated liability is a known
obligation of an uncertain amount, but
one that can be reasonably estimated.
Warranty: Sellers obligation to replace or correct a
product (or service) that fails to perform as
expected within a specified period. To conform with
the matching principle, the seller reports expected
warranty expense in the period when revenue from
the sale is reported.
McGraw-Hill/Irw32in

The McGraw-Hill Companies, Inc., 2006

Corporation

Issuing stocks: common / preferred stocks

Distribute dividends: cash / stock dividends
Stock splits
Treasury Stock
Earning Per Share

McGraw-Hill/Irw33in

The McGraw-Hill Companies, Inc., 2006

Bond Discount or Premium

Prepare the entry for Jan. 1, 2005 to record the following
bond issue by Rose Co.
Par Value = $1,000,000
Issue Price = 92.6405% of par value
Stated Interest Rate = 10%
Market Interest Rate = 12%
Interest Dates = 6/30 and 12/31
Bond Date = Jan. 1, 2005
Maturity Date = Dec. 31, 2009 (5 years)

McGraw-Hill/Irw34in

Contract rate is:

Bond sells:
Above market rate
At a premium
Equal to market rate At par value
Below market rate
At a discount
The McGraw-Hill Companies, Inc., 2006

Issuing Bonds at a Discount

On Jan. 1, 2005 Rose Co. would record the
bond issue as follows.
Jan. 1

Cash
Discount on bonds payable
Bonds payable

926,405
73,595
1,000,000

Sold bonds at a discount on issue date

Contra-Liability
Account
McGraw-Hill/Irw35in

The McGraw-Hill Companies, Inc., 2006

Issuing Bonds at a Discount

Make the following entry every six months to
record the cash interest payment and the
amortization of the discount.
June 30

Bond interest expense

Discount on bonds payable
Cash

57,360
7,360
50,000

Paid semi-annual interest and amortized discount

$73,595 10 periods = $7,360 (rounded)

$1,000,000 10% = $50,000

McGraw-Hill/Irw36in

The McGraw-Hill Companies, Inc., 2006

Issuing Bonds at a Premium

On Jan. 1, 2005 Rose Co. would record the
bond issue as follows.
Jan. 1

Cash

1,081,145
Premium on bonds payable
Bonds payable

81,145
1,000,000

Issued bonds at a premium on issue date

Adjunct-Liability
Account

McGraw-Hill/Irw37in

The McGraw-Hill Companies, Inc., 2006

Issuing Bonds at a Premium

This entry is made every six months to
record the cash interest payment and the
amortization of the premium.
June 30

Bond interest expense

Premium on bonds payable
Cash

41,885
8,115
50,000

Paid semi-annual interest and amortized premium

$81,145 10 periods = $8,115 (rounded)

$1,000,000 10% = $50,000

McGraw-Hill/Irw38in

The McGraw-Hill Companies, Inc., 2006

Classes of and Reporting for Investments

Class of Investment
Held-ToMaturity

Amortized
Cost

Trading

AvailableFor-Sale

Market Value
Method

Significant
Influence

Controlling
Influence

Equity
Method

Consolidate

Reporting
McGraw-Hill/Irw39in

The McGraw-Hill Companies, Inc., 2006

Classifying Cash Flows

The Statement of Cash Flows includes the
following three sections:
Operating Activities
Investing Activities
Financing Activities

McGraw-Hill/Irw40in

The McGraw-Hill Companies, Inc., 2006

Analyzing the Cash Account

Balance, Jan.
Receipts from
Receipts from
Receipts from

1, 2005
customers
sale of land
stock issuance

Balance, Dec. 31, 2005

Cash
22,000 Payments for merchandise
466,000 Payments for wages
25,000 Payments for interest
35,000 Payments for taxes
Payments for equipment
Payments for bond retirement
Payments for dividends
63,000

150,000
145,000
10,000
20,000
70,000
50,000
40,000

Lets use this Cash account to prepare

B&G Companys Statement of Cash
Flows under the Direct Method.
McGraw-Hill/Irw41in

The McGraw-Hill Companies, Inc., 2006

Indirect Method of Reporting Operating

Cash Flows
Changes in current assets
and current liabilities.

Cash Flows
from Operating
Activities

Net
Income
+ Losses and
- Gains

+ Noncash
expenses such as
depreciation and
amortization.

97.5% of all companies use the indirect method.

McGraw-Hill/Irw42in

The McGraw-Hill Companies, Inc., 2006

Tools of Analysis

Horizontal Analysis
Comparing a companys financial condition
and performance across time

Time
McGraw-Hill/Irw43in

The McGraw-Hill Companies, Inc., 2006

Tools of Analysis
Comparing a companys
financial condition and
performance to a base amount

V
e
r
t
i
c
a
l
A
n
a
l
y
s
i
s

McGraw-Hill/Irw44in

The McGraw-Hill Companies, Inc., 2006

Tools of Analysis
Using key relations
among financial
statement items

McGraw-Hill/Irw45in

The McGraw-Hill Companies, Inc., 2006

Building Blocks of Analysis

Ability to meet
short-term
obligations and
to efficiently
generate
revenues

Ability to provide
financial rewards
sufficient to
attract and retain
financing
McGraw-Hill/Irw46in

Liquidity
and
Efficiency

Solvency

Market
Profitability
Prospects

Ability to
generate future
revenues and
meet long-term
obligations

Ability to
generate
positive
market
expectations

The McGraw-Hill Companies, Inc., 2006

Computing Break-Even Point

Sales Revenue (2,000 units)
Less: Variable costs
Contribution margin
Less: Fixed costs
Net income

Total
$ 100,000
60,000
$ 40,000
30,000
$ 10,000

Unit
$ 50
30
$ 20

How much contribution margin must this company

have to cover its fixed costs (break even)?
Answer: $30,000
McGraw-Hill/Irw47in

The McGraw-Hill Companies, Inc., 2006

Computing Sales (Dollars) for a

Target Net Income

Exh.
22-14

Target net income is income after income tax.

Dollar sales =

McGraw-Hill/Irw48in

Fixed + Target net + Income

costs
income
taxes
Contribution margin ratio

The McGraw-Hill Companies, Inc., 2006

Computing Multiproduct
Break-Even Point

Exh.
22-19

The resulting break-even formula

for composite unit sales is:
Break-even point
in composite units

Fixed costs
Contribution margin
per composite unit

Consider the following example:

Continue
McGraw-Hill/Irw49in

The McGraw-Hill Companies, Inc., 2006

Net Present Value

with Even Cash Flows

Exh.
26-7

Present
Present
Annual Net Value of $1
Value of
Year
Cash Flows
Factor
Cash Flows
1
$
4,100
0.8929 $
3,661
2
4,100
0.7972
3,269
3
4,100
0.7118
2,918
4
4,100
0.6355
2,606
5
4,100
0.5674
2,326
6
4,100
0.5066
2,077
A positive
net present
indicates that
this
7
4,100 value
0.4523
1,854
project earns
more than
8
4,10012 percent
0.4039on the investment.
1,656
Total
$
32,800
$
20,367
Amount to be invested
(16,000)
Net present value of investment
$
4,367
McGraw-Hill/Irw50in

The McGraw-Hill Companies, Inc., 2006

Internal Rate of Return (IRR)

The interest rate that makes . . .

Present
value of
cash inflows

Present
value of
cash outflows

The net present value equal zero.

McGraw-Hill/Irw51in

The McGraw-Hill Companies, Inc., 2006

Relevant Costs
Costs that are applicable
to a particular decision.
Costs that should have a
bearing on which alternative
a manager selects.
Costs that are avoidable.
Future costs that differ
between alternatives.
McGraw-Hill/Irw52in

The McGraw-Hill Companies, Inc., 2006